Why insider dealing is so attractive to hedge funds

By Felix Salmon

June 27, 2011

post about Raj Rajaratnam and insider trading, points out how small Raj's insider profits were, compared to his net worth and the size of his fund: "
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Danny Black, in a series of comments on my post about Raj Rajaratnam and insider trading, points out how small Raj’s insider profits were, compared to his net worth and the size of his fund:

One of the interesting things is just how [relatively] tiny the sums the insider trader makes. Rajaratnam was worth 1.8bn USD at one point. The upper end of what he made was 60mn. If I told you I could increase your wealth by 3% over a number of years but you might spend a decade or so in federal jail would you take up the offer?

This I think is doubly wrong. For one thing, $60 million is emphatically not an upper bound for the amount of money that Raj made on insider trading. Raj was not new to this game when his phones started being tapped, and it’s incredibly naive to think that all of his insider dealing was conducted, in one way or another, over the phone. $60 million is the upper bound for trades which the authorities considered prosecutable; it’s nowhere near being an upper bound even for what he made while his phone was tapped, let alone what he made over the course of his career.

But even that understates the value of insider trading to a hedge fund manager. Raj made his billions by collecting 2 and 20 from outside investors in Galleon: the path to hedge-fund riches is, always, to maximize assets under management. And if there’s one thing that hedge-fund investors are looking for, it’s alpha — that small edge which the best managers are believed to have over the market as a whole.

To a hedge-fund manager, then, $60 million in excess profits can be worth vastly more than $60 million. If it persuades outside investors that you can generate more alpha than anybody else, and those investors end up giving you an extra few billion dollars to invest as a result, and you take 2-and-20 on those extra few billion dollars, then at that point you’re making real money.

Running a hedge fund, in this sense, is a way of leveraging any insider trades you find many times over. They don’t just make money in and of themselves: they also help you attract all-important AUM. Given that calculus, it’s easy to see why Raj found insider dealing so attractive. Without it, he might never have become a billionaire in the first place.